Mechanism Design Theory and recent crisis

This post is almost a month old. The Economics prize in memory of Alfred Nobel (wrongly called as Nobel Prize for Economics, read Taleb’s criticism for the same here) was given to 3 economists who have (ofcourse) pioneered the field of Mechanism Design Theory.

Nobel Committee has done some explaining of the same here (basic version) and here (advanced version). Sicne then, there are a lot of links explaining the same and most can be found doing a simple google search. In particular see this superb post by Alex Tabarrok of Marginal Revolution.

To me it is an extension of 2 basic ideas to which Nobel committee has already rewarded earlier- importance of institutions (in 1993to North and Fogel) and information asymmetry (in 2001 to Akerlof, Spence and Stigilitz). There are many roles of institutions but one very important role is that they help reduce information asymmetry in markets. Now the next question is how do you design these institutions, in other words how do you make these institutions function?This is what MDT helps in answering. The field is highly abstract but has a lot of applications in real life. (Read Tabarrok article).

Jeff Lacker of Richmond Fed has given a nice speech linking MDT and the recent crisis.

Mechanism design theory provides an approach for addressing precisely these questions about how institutions arise and adapt in response to incentive and information problems. This approach then allows us to study and compare the diverse institutions that exist in an economy and play a role in the allocation of resources — markets, firms, banks, clearing houses, and even central banks and governments. More precisely, these contractual and institutional arrangements all constitute alternative mechanisms for allocating resources, and the approach is to study the properties of the best possible resource allocations that any mechanism is capable of achieving. For example, how well does it do at funding appropriate investments and allocating the attendant risk? One can then compare how close alternative mechanisms come to achieving those allocations. If one set of arrangements can achieve superior allocations, but others cannot, then one has a candidate explanation for why such an intermediary might exist.

Read the whole speech to get another perspective on MDT and recent crisis.

Who was Milton Friedman?

Paul Krugman had written a piece in Feb-07 NY review of Books titled the same which looked controversial from the word go. There was a replyto Krugman’s piece from Anna Schwartz (along with Edward Nelson) who coauthored Friedman in the epic- “A Monetary History of the United States, 1867 – 1960″.

Krugman replied (just scroll below on the same page). To answer Krugman, Nelson and Shwartz have written a paper on the same as they feel NY review is not an appropriate place to handle the topic.

I have not read the detailed paper by Shwartz but managed to read Krugman’s views on Friedman and was quite taken aback. It is fine to criticise someone’s views but not in this fashion really and that too when Friedman is no more (I would have loved to hear Friedman’s answer to Krugman) . Economists mostly disagree and criticise each other’s views and that is what has helped the field grow.

Anyways, Krugman’s piece is a neat summary of Friedman’s research. The interpretation obviously depends on the reader.

Monetary Policy History

Bundesbank organised a conference celebrating its 50 years. I had covered two papers from the conference by Mishkin and by Svensson.

David Laidler presented a super paper on History of Monetary Policy titled ‘Sucess and failure of monetary policy since the 1950s’.

The paper is more interesting as it also presents a political angle to the history of monetary policy and the way it emerged as central to policymaking.

It begins by looking at Bretton Woods system and exchange rate targeting regime followed by most countries as inflation was never really considered a worry. The paper then looks at advent of inflation and how central banks and government in different countries responded to it.

The paper is very well written and is very precise (just about 24 pages) and a must read for monetary policy followers.

Assorted Links

1. TTR shareshis views on capital controls. He responds to this newswhich says RBI and Finance Ministry are planning new measures  to curb capital controls especially ECBs. The measures include auctioning ECB loans and sterilization tax. Here is what TTR says:

I don’t believe these measures will be effective enough. The government should have a better capacity to sterilise. For this, it needs to have a bigger war chest of market stabilisation bonds and it also needs to bring down domestic rates. It must also act to make returns to investment in India less attractive through, for instance, introducing long-tax capital gains tax on equities.

I am not sure whether lowering down interest rates would help. The banks to give more loans to corporates, leading to more expansion and further  surge in equity markets meaning more capital inflows. Even more MSS bonds would mean higher costs for the government and with FRBM in place, I am not sure whether it is a good strategy.

2. MR points to an excellent article on America’s excessive risk taking.

3. WSJ Blog points to an excellent debate on what makes an industrial revolution, Bernanke being humble, a possibility of 5% inflation at X-mas?

4. Mankiw points to economics of loosing weight.

5. Rodrik on science of exchange rates

6. ESAP Blog on the 3rd inconvenient truth about India’s growth – only the western and southern states are growing.

7. Econbrowser discusses possibility of rising inflation. Excellent.

8. Ajay Shah points Malaysians influence Indian policymakers.